Reducing Your Capital Gains Tax Bill

The end of the calendar year can be a good time to try to reduce the amount you have to pay in taxes. You have to pay capital gains taxes on your investments that have been sold for a profit during the year (at least in standard investment accounts; you don’t have to worry about this in tax-advantaged accounts such as 401k, IRA, and 529 accounts). But if you also have investments that have declined in value, you could potentially sell some of these before the year ends to create “capital losses” to offset the capital gains. This tactic, called “tax-loss harvesting,” can lower the amount you pay in taxes and therefore boost the size of your portfolio over time.

Unfortunately there are a few nuances that can make successful tax-loss harvesting more difficult. The first is that you can’t sell an investment to lock in the loss and then immediately buy it back. The IRS calls this maneuver a “wash sale” and prevents you from getting any tax benefit from it. Instead you have to wait more than 30 days before re-purchasing the same investment (or any investment that the IRS considers to be essentially the same). Capturing the tax benefit from capital losses without creating a distorted portfolio while you wait for the 30-day period to end can be difficult.

A further complication is that the tax rate on capital gains can be different for different people, or even for different investments held by the same person. For example, the tax rate on gains from investments held more than a year (“long-term capital gains”) is lower than the tax rate on gains from investments held less than a year (“short-term capital gains”). That means that figuring out how much you can actually save through tax-loss harvesting can be tricky.

The bottom line is that tax-loss harvesting can potentially be an effective way to reduce the hit to your portfolio from taxes. But with so many subtleties involved in successfully implementing it, having a professional financial advisor guide you through the process may be a good idea.